Inflation, Disinflation and Deflation

There are far too many inadequate impressions about deflation going around.

A policy culture dedicated to "stimulation" through forced credit
expansion with the attendant currency depreciation makes any discussion about
deflation seem alien. Unfortunately, even resorting to an economics dictionary
is not too helpful.

Disinflation, being benign, is described as a "planned reduction" in
the general price level. Being destructive, both inflation and deflation are
described as "sudden", laying off any blame upon misguided consumers.
The deliberate misunderstanding of the "flations" - either "in" or "de" -
was contrived by Keynes in the early 1930s. Until then, inflation was considered
as an inordinate expansion of credit - the result was rising prices. In a series
of letters to senior Fed staffers, he argued instead that inflation was rising
prices.

Lately, and mainly limited to the mainstream, there has been some confusion
about how credit could soar during the 1990s with so little CPI inflation.
Although credit was inflating against soaring financial assets, pundits touted
that you had to buy the stock market "because there is no inflation".
This was also the case in the 1920s' boom, which brings us to some "rules" for
deflation. There are only two types: minor and severe.

The minor type occurs when a raging mania in tangible assets becomes unsustainable
and collapses. Although painful, the deflation is mainly limited to commodity
and real estate prices. More recent examples occurred in 1990-1991 and in 1920-1921.
All together, there have been six since the one in 1711 that set up the infamous
South Sea Bubble of 1720.

In all cases, the minor deflation set up the exceptional abuse of the credit
markets otherwise known as a "New Financial Era". Each ended in a
dramatic climax that, except for ours, was identified in real time as a bubble.
The consequent deflation included both the main asset classes - financial and
tangible - and can be described as severe with profound and lasting consequences.

As they occurred in the senior financial centre (London and then New York),
all five examples from 1720 to 1929 were followed by initially severe deflation
within a prolonged credit contraction. This year's outstanding recovery in
the stock market and narrowing of credit spreads seems to be defying history.

However, there are indications that the post-2000 bubble period has some similarities
with the prolonged initial contraction following the 1873 financial extravaganza.
On a more generalized basis, some conditions common and unique to all post-bubble
periods have been developing. The most obvious is the senior central bank following
a massive decline in short rates with a remarkable string of discount rate
cuts.

Other identification is provided by the statistically significant cluster
of defaults. Sadly, after claiming credit for the boom, suddenly chagrined
politicians seek solace in recriminatory legislation and attacking individual
scapegoats. (See comments on the 1618 severe deflation below.)

Those who are rushing to form "super" agencies with a "super" fix
now haven't taken the time to realize that the SEC was formed in 1934 to prevent
another runaway stock market and consequent severe deflation. Although such "prosperity" must
be considered as ephemeral, in all cases soaring tax revenues have beguiled
any government from acting responsibly or discovering malfeasance until it
was too late. Promoters of the 1934 SEC Act boasted it "would put a cop
at the corner of Wall and Broad Streets". Where were the "cops" in
1999 and 2000?

Many have found their curiosity about financial markets fully satisfied by
rather personal theories about credit intervention promoted in best-selling
textbooks. Fortunately, financial history provides more practical instruction.
It goes back a long way and shows that there is very little that is new - including "New
Financial Eras". It is also a devastating critique on every interventionist
theory.

Modern finance started in the 1680s with the evolution of a stock market.
This was formalized with the advent of independent research with John Houghton's
market letter in 1692 and the start of central banking with the Bank of England
in 1694.

For hundreds of years prior to this, and without a stock market, the great
speculative moves were limited to tangible assets. But the basic timing pattern
was similar. Tangible assets reached an excess and rapidly collapsed. Then,
with business stagnating, many government loans became unserviceable nine years
later, resulting in a cluster of devastating defaults.

A prototypical "new era" started with the end of inflation in 1609.
The immediate hard recession (but minor deflation) and subsequent poor pricing
abilities created widespread unemployment, particularly in the cloth trade.
Then England shipped basic cloths to the Netherlands, which was the financial
and commercial centre of the world. Those who didn't know better became envious
of the "value added" obtained by finishing the cloth in Flanders
and promoted a scheme to capture this by keeping and finishing the cloth in
England. Today, this would be the equivalent of taking Western Canada's raw
materials and making cars to sell to Japan. In a post-inflation contraction,
it is impossible to support existing, let alone additional, capacity.

With the sluggish economy, a promoter persuaded the British Crown to finance
the duplication in England of cloth-finishing facilities. As business conditions
began to deteriorate in 1618, the King became apprehensive - particularly as
successful merchants described the scheme as "a Sepulcher - attractive
without, Dead bones within".

Then in November of that fateful year, which was seasonally appropriate for
financial calamity, the Archbishop recorded that the King told the advisor, "in
could bloud before ye Council Table yet if he had abused him by wrong information
his 4 quarters should pay for it". As this meant "hanged, drawn and
quartered", the Archbishop continued with "ye poore Alderman stood
infinitely amazed".

As the scheme included supporting the home industry by buying unfinished cloths,
it prompted other practical comment.

A well known letter-writer by the name of Chamberlain observed that it was
strange that "the wisdome of the state could be induced to [rely upon]
the vaine promises of ydle braines".

Another rule of deflation is that it prompts remedies by those without an
intimate understanding of a great boom and its consequent contraction. Virtually
all of the available credit is employed during the mania. Credit does not drive
prices up, but the collateral value of soaring prices permits the credit expansion.
Then, as asset prices fall, diminishing collateral values and falling commodity
prices force a credit vacuum whereby those few participants with the experience
and character to get liquid during the mania won't risk it until the contraction
naturally ends. In more recent terms, banks who wish to survive will only lend
to AAA credits who, in turn, protect that rating by not borrowing.

A credit vacuum is as rich a territory for "ydle brains" as was
the boom. In the post-1618 distress (or severe deflation), Misselden, with
inadequate experience, proposed " As it is the scarcity that maketh the
high rates of interest, so the plenty of money will make the rates low."

Virtually every distressful severe deflation has prompted the same remedies.
Prior to his "Mississippi Bubble" of 1720, John Law, the first central
banker to briefly enjoy a personality cult, observed "Domestick trade
depends upon money. A greater quantity employes more people than a lesser quantity."

(It is worth noting that in the 1720 bubbles England was on a gold standard
so its speculation was associated solely with credit creation. France was on
John Law's fiat currency and, even with 8 printing presses running, the central
bank was unable to extend the boom beyond nine years.)

With no fear of plagiarism, Keynes also recommended the ancient misunderstanding
that a credit vacuum and deflation that normally follows the expenditure of
available credit during the mania can be turned around by the artificial injection
of credit by some very earnest agency. (Friedrich Hayek recalled that when
Keynes was contriving his remedies, he was totally ignorant of financial history.)

Other than direct experience, financial history is the best teacher. Indeed,
financial history itself can be considered as a due diligence on the theory
of credit intervention as it has been "discovered" during each significant
credit contraction.

It is essential to have a clear understanding of the three "flations".
Fortunately, history provides sufficient evidence to provide sound usage of
the terms. Inflation is an extraordinary expansion of credit associated with
soaring prices. This can be against tangible or financial assets and the way
history works is that a bubble in real assets has preceded every bubble in
financials by nine years - but never both at the same time. Disinflation is
a more recent term and it has been reasonably used to describe the lack of
soaring prices for tangibles that is the feature of every financial mania.

Minor deflation has followed the great booms in tangible assets and severe
deflations have been the consequence of New Financial Eras and their culminating
bubbles.

Will the new financial era that ended in 2000 be followed by a traditional
example of severe deflation with weak prices for financial and tangible assets
forcing a credit contraction? Will gold provide the liquidity needed in such
a crisis as well as the typical outstanding performance seen in other post-bubble
periods? History suggests yes and probability can provide some guidance. While
there is no guarantee that it will happen yet again, there is no guarantee
that it won't.

The opinions in this report are solely those of the author.
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